The authors Iain Clacher & Con Keating

This is the fifth in our series of blogs addressing the questions posed in the DWP’s Funding Regulations consultation.  Links to the previous blogs are provided at the end of this blog. We follow the same conventions as in previous blogs.

We continue with the next questions posed in the Consultation. These are concerned with the level of detail of the Funding and investment strategy

Question 14: Is the level of detail required for the funding and investment strategy by draft regulation 12 reasonable and proportionate?

Question 15: Do you think the requirement for high level information on expected categories of investments will impact trustees’ independence in making investment decisions in the interests of scheme members?

We reproduce Regulation 12 below:

12. For the purposes of section 221A(4)(b) of the Act (funding and investment strategy: level of detail)

(a) the funding and investment strategy must set out the way in which the trustees or managers intend pensions and other benefits under the scheme will be provided over the long term;

(b) in the case of a scheme which has not reached the relevant date, the funding and investment strategy must set out the expected maturity of the scheme at the relevant date; [Emphasis Added]

 (c) the information required about the investments the trustees or managers intend the scheme to hold on the relevant date is the proportion of the assets of the scheme intended to be allocated to different categories of investments.

The narrative on this Regulation in the draft is sparse and ambiguous: Regulation 12 makes provision regarding the level of detail required in a funding and investment strategy. The narrative of the Consultation is fuller but misleading:

“ 39. … Draft regulation 12(b) requires the funding and investment strategy to set out the expected duration of the scheme’s liabilities at the relevant date, where a scheme has not yet reached that date.” [Emphasis Added]

The Regulation requires the disclosure of the expected maturity of the scheme not the expected duration of it.

“3.40. Draft regulation 12(c) provides that the level of detail about the information on scheme investments required to be included in the funding and investment strategy by section 221A(2)(b) of the Pensions Act 2004 is the proportion of assets that the trustees or managers expect to allocate to different categories of investment. By categories of investment, we mean high level asset classes such as equities, corporate bonds and gilts. The funding and investment strategy will not therefore include information on actual scheme investments. Employers are responsible for funding their defined benefit pension schemes and will therefore need to agree the funding and investment strategy. But trustees will continue to be responsible for investing funds on behalf of scheme members and employer agreement is not required for all other investment decisions.” [Emphasis Added]

This is an interpretation of other aspects of pension regulation; it is not a consequence of Regulation 12. The narrative is, to put it mildly, confusing.

Question 14: Is the level of detail required for the funding and investment strategy by draft regulation 12 reasonable and proportionate?

Response: The Regulation does not in fact specify any level of detail; it merely states the elements required. We note that for many open schemes the relevant date would be undefined. It would only be by indulging in counterfactual scenarios, such as the immediate closure of the scheme to new members, that such a date would become defined. This would be a pointless exercise and completely disproportionate.

But schemes are already being asked to indulge in fantasy with “(c) the information required about the investments the trustees or managers intend the scheme to hold on the relevant date is the proportion of the assets of the scheme intended to be allocated to different categories of investments.” as is made clear by the narrative’s “The funding and investment strategy will not therefore include information on actual scheme investments”.

We do not believe that this regulation is either sensible or even feasible in any objective manner. The asset allocation at any date, including those in the future, should reflect the economic and financial conditions prevailing at that time.

As these may be far in the future, they would be unknowable – deep in the land of uncertainty rather than probability. In order to understand this more fully, and to avoid writing a treatise ourselves, we recommend reading Radical Uncertainty: Decision-Making for an Unknowable Future by John Kay and Mervyn King.

In recent years, a sub-discipline has developed within the economics profession which is concerned with behavioural biases and their effects on decisions. In his book, The Road Ahead, Bill Gates offered a useful and relevant aphorism

“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.”

Given that the regulated and the Regulator may differ in their visions of the future, and with that, in their desired asset allocations, the regulation will be unenforceable, as neither party can, in any meaningful sense, prove their vision. Alternatively, the (unelected and largely unaccountable) Regulator will publish its guidance. That guidance will suffer from recency – bias. It will over react to short term events; a recent example is the intervention of the Regulator in the last Universities Superannuation Scheme valuation. Many investment consultants and other advisers will accept the guidance uncritically and encourage the trustees to follow.  There are very real consequences:

• it will lead to value destruction on a grand scale as the cost of providing pensions increases in consequence; think of the LDI strategies
• pro-cyclicality will be encouraged,
• jobs will be destroyed as employers divert money out of productive investment into the pension fund to be invested in gilts with a negative real investment return,
• the cost to the taxpayer will increase (tax relief on employer contributions).

The effect on security for member benefits will be at best marginal and, by weakening  the employer covenant for some schemes, make the position worse.  Not exactly a strategy for growth in keeping with the latest  Government policy:

Question 15: Do you think the requirement for high level information on expected categories of investments will impact trustees’ independence in making investment decisions in the interests of scheme members?

Response: This is a legally illiterate question. The trustees’ power to set the investment strategy is being restricted by the proposed regulations. It follows that the trustees’ ability to invest in the interests of scheme members is, in turn, being constrained. As to the consequences, see, for example, the response  to Question 14 above.

The next section of the Consultation is concerned with Determination, review and revision of funding and investment strategy, and specifically with Regulation 13. It poses the following:

Question 16: Are the requirements and timescales for determining, reviewing and revising the funding and investment strategy in draft regulation 13 realistic?

 The explanatory note for the Regulation simply states: Regulation 13 sets out the period within which a funding and investment strategy must be determined and subsequently reviewed and revised.

 The Regulation sets 15 month timescales as the limit for reports for most circumstances, though it reduces the to six month or three month periods other than for Regulation 13 (2) (e ) where the requirement would be: “as soon as reasonably practicable after any material change in the circumstances of the pension scheme or of the employer in relation to the scheme. “

This is supplemented by: 3.44. Draft regulation 13(3) specifies that the material changes in the circumstances of the pension scheme or the employer in draft regulation 13(2)(e) include, but are not limited to, a material change in the:

• value of the assets of the scheme relative to the value of its liabilities;
• maturity of the scheme; or
• strength of the employer covenant.

Response: It is difficult to provide a meaningful answer to this question until it is clear how the maturity date/maturity of  the scheme is to be defined.

Let us now do a thought experiment and assume that the regulations in their current form came into force on 1^st January, 2022. The maturity of our example scheme would have changed (to end August) from 16.7 years to 14.4  years, a change of more than 13% percent.

On any analysis that would, based on the proposed maturity date determination methodology, be material.  So, what would the DWP envisage that the trustees should do in that situation and what do they envisage the cost would be to the pension scheme and how would they calculate it?  Should the trustees just redo the statement of funding and investment strategy and make no change to the scheme’s investment strategy? Or should they change the investment strategy?  Time and money are finite, and prioritisation has to be made.

The Consultation next moves to the Statement of Strategy and rapidly to Supplementary Matters. It poses just one question.

Question 17: Are there any other assessments or explanations that trustees should evidence in Part 2 of the statement of strategy?

This is extremely surprising as most of the implementation detail is laid out here. As the explanatory notes state:  “Part 3 of these Regulations makes provision regarding the statement of strategy. The statement of strategy is prepared by the trustees or managers of a scheme under section 221B of the 2004 Act (statement of strategy). It consists of two parts: Part 1 is a written statement of the funding and investment strategy and Part 2 is a written statement of supplementary matters.”

Though the Consultation is only concerned with Regulations, we should consider the context in which they are framed. We have added our comments after each subsection. The Pensions Act 2004, after revision by the Pensions Scheme Act 2021, contains section 221 B Statement of strategy of which subsection (2) states:

(2)The supplementary matters are—

(a)         the extent to which, in the opinion of the trustees or managers, the funding and investment strategy is being successfully implemented and, where it is not, the steps they propose to take to remedy the position (including details as to timing);

This is an onerous and costly to implement requirement

(b)         the main risks faced by the scheme in implementing the funding and investment strategy and how the trustees or managers intend to mitigate or manage them;

This is not only onerous and costly, but it is debatable if it is actually feasible.

(c)          reflections of the trustees or managers on any significant decisions taken by them in the past that are relevant to the funding and investment strategy (including any lessons learned that have affected other decisions or may do so in the future);

This moves beyond the sublime and ridiculous to the outright farcical. One of the authors of this blog has been taking investment decisions as a trustee since 1967. Such reflections would occupy several large volumes, such reflections would take many years to prepare and a remarkable tolerance for the mundane to read. What purpose can there be to this requirement?

(d)         such other matters as may be prescribed.

This is the subject of Regulation 14 and in turn Schedule 2 of the regulations:

Supplementary matters

14. For the purposes of section 221B(2)(d) of the Act (statement of strategy) the matters prescribed are set out in Schedule 2. We reproduce this Schedule below.

 Schedule 2

Statement of strategy – supplementary matters

 For the purposes of section 221B(2)(d) of the Act, the supplementary matters are set out in paragraphs 2 to 19.

 Maturity

2. The actuary’s estimate of the maturity of the scheme as at the effective date of the actuarial valuation to which the funding and investment strategy relates, as set out in that valuation.
3. For a scheme which has not reached the relevant date, how the maturity of the scheme is expected to change over time.

 Investment risk

4. The current level of risk in relation to the investment of the assets of the scheme.
   5. For a scheme which has not reached the relevant date— (a) the level of risk the trustees or managers of the scheme intend to take in relation to the investment of the assets of the scheme as it moves along its journey plan;

(b) how this complies with the principles in paragraph 4 of Schedule 1; and

(c) how the trustees or managers intend to achieve compliance with the principle in paragraph 3(2)(b) of Schedule 1 by the relevant date.

For a scheme which has reached the relevant date, how the current level of risk complies with the principle in paragraph 3(2)(b) of Schedule 1.

 Liquidity

7. How the investments of the assets of the scheme comply with the principle in paragraph 6 of Schedule 1.

 Funding level

8. The funding level of the scheme as at the effective date of the actuarial valuation to which the funding and investment strategy relates, as set out in that valuation.
9. For a scheme which has not reached the relevant date— (a) the assumptions used in specifying the funding level the trustees or managers intend the scheme to have achieved as at the relevant date; and

(b) how these are different to the assumptions used in calculating the scheme’s technical provisions in the actuarial valuation to which the funding and investment strategy relates.

10. For a scheme which has reached the relevant date, the assumptions used in the actuary’s estimate of the funding level of the scheme as at the effective date of the actuarial valuation to which the funding and investment strategy relates.

 Technical provisions

11. The discount rate or rates and other assumptions used in calculating the scheme’s technical provisions in the actuarial valuation to which the funding and investment strategy relates.
12. How the trustees or managers of the scheme expect the discount rate or rates to change over time.

 Risk in relation to calculation of liabilities

13. How the level of risk taken in determining the actuarial assumptions used for the purposes of calculating the liabilities of the scheme complies with the principles in paragraph 5 of Schedule 1.

 Employer covenant

14. An assessment of the strength of the employer covenant.
15. How long it is reasonable to rely on this assessment.
16. Any changes in the strength of the employer covenant since the last review of the statement of strategy.

 General

17. The extent to which the funding and investment strategy is or remains appropriate.
18. Confirmation that the trustees or managers have consulted the employer in relation to the scheme in the preparation or revision of Part 2 of the statement of strategy.
19. Any comments that the employer in relation to the scheme has asked to be included in Part 2 of the statement of strategy.

 Not one of these points are open to question or discussion in the Consultation paper, though Parliament is expected to rubber stamp the Funding Regulations and pass it into law. We find this unacceptable. We will provide a discussion of all of these points together with Regulation 15 for Parliamentary discussion and debate, separately.

Regulations tend not to be debated, their passage through Parliament by affirmative or negative resolution, but it is essential that these are. The question posed takes these points as given, settled, and indeed also the entirety of Regulation 15, which covers Part 2 of the statement of strategy – level of detail. As this Regulation 15 also references Schedule 2, we reproduce that fully below:

15. (1) This regulation makes provision regarding the level of detail required in Part 2(a) of a statement of strategy.

•  (2) In relation to the requirement to prepare a written statement of the main risks faced by the scheme in implementing the funding and investment strategy and how the trustees or managers intend to mitigate or manage them, the statement of strategy must include a section setting out what action the trustees or managers intend to take in the event that the risks identified materialise.
•  
• (3) In relation to the requirement to prepare a written statement of the current level of risk in relation to the investment of the assets of the scheme, and (if applicable) the level of risk the trustees or managers of the scheme intend to take in relation to the investment of the assets of the scheme as the scheme moves along its journey plan, the statement of strategy must include a section setting out
  • (a) the proportion of the assets allocated to different categories of investments;
• (b) in the case of a scheme which has not reached the relevant date, the proportion   of assets intended to be allocated to different categories of investments as the scheme moves along its journey plan; and

(c) for each category of investments set out, such further information as is needed to explain what the level of risk is relating to those investments.

(4) In setting out the matters in paragraphs 3 to 7 and 12 to 17 of Schedule 2, the trustees or managers must explain the evidence on which these are based.

Regulation 16 is also captured by the single question. It states:

16. For the purposes of section 221B(4) of the Act, the trustees or managers must review and, if necessary, revise Part 2 of the scheme’s statement of strategy and prepare a statement of strategy incorporating the revised Part 2 as soon as reasonably practicable after any review of the scheme’s funding and investment strategy, whether or not the funding and investment strategy is revised. [Emphasis Added]

 This is nonsensical make-work, a full employment charter for investment consultants and advisors; what purpose can be possibly be served by such a revision when there is no change to the funding and investment strategy?

The Consultation asks only for more: “Are there any other assessments or explanations that trustees should evidence in Part 2 of the statement of strategy?” to which our response is absolutely not.

Previous Blogs

Blog 1: https://henrytapper.com/2022/08/10/con-keating-and-iain-clacher-appalled-by-dwps-proposed-funding-regulations/

Blog 2: https://henrytapper.com/2022/08/16/keating-and-clacher-explain-the-threat-from-the-proposed-dwp-funding-regulations/

Blog 3: https://henrytapper.com/2022/09/01/the-theoretical-and-analytical-basis-for-the-dwps-funding-regulations-are-not-fit-for-purpose/

Blog 4: https://henrytapper.com/2022/09/06/comply-or-explain-becomes-comply-or-else-keating-and-clacher-on-dwp-funding-regs-4/